By now, many readers may have seen the 2012 Towers Watson D&O insurance survey, entitled “Directors and Officers Liability: 2012 Survey of Insurance Purchasing Trends,” which can be here. (I am only belatedly posting a link to the survey now owing to my travel schedule last week, when Towers Watson released the survey report).

 

As always, the survey report contains a number of interesting insights, including in particular the report’s conclusion that “the insurance marketplace for directors and officers liability is clearly firming, as evidenced by increased pricing experienced in many sectors.”

 

The report contains a number of other interesting insights about the current D&O insurance marketplace for both public and private/nonprofit entities, but readers will also want to note the precautionary comment in the report’s introduction, which state that “it is important that care is taken”  in drawing conclusions from the report owing to the fact that  "the majority of respondents were large organizations with total assets/revenues in excess of US$1 billion” and that “firms with assets/revenues under US$1 billion were not as well represented.”

I know that much of this blog’s readership is located outside the United States and that many readers have substantial business dealings overseas. One of the countries that I know many are focused on is India. For that reason I am pleased to be able publish the following guest from Michael Lea and Abhimanyu Malkan of JLT Specialty Limited (pictured, left)..Mike is Partner and Head of Management Liability in JLT’s Financial Risks Division and is based in London. Abi is a Research Analyst in JLT’s Financial Risks Division and is based in Mumbai.

 

I would like to thank Mike and Abi for their willingness to publish their article on this site. I welcome guest posts from responsible commentators on topic of relevance to this blog. Readers interested in publishing a guest post are encouraged to contact me directly. Here is Mike and Abi’s  article:

 

 

 

The Indian government has decided to replace almost six decades of company law governing the companies in India, i.e. Companies Act, 1956 (CA1956) by new law, the Companies Act 2012 (CA 2012). The proposed Indian Companies Bill (CA 2012) has been passed by the lower house of Indian Parliament, however, approval by the upper house is still pending.

 

In this post, we examine the directors & officers (D&O) insurance market in India which is of particular relevance to many companies who deal with India, particularly the US. The current regulations in the proposed bill along with D&O related issues have created a conducive environment to selling D&O insurance in India.

 

Background

 

Most company executives generally understand that D&O insurance is useful given the changing landscape of regulations in India coupled with the recent spate of global claim experiences which has brought risk factors associated with directors and officers into significant prominence. The expansion of global footprints of Indian companies coupled with a complex regulatory environment, increased shareholder activism and litigation has made the job of directors and senior executives onerous and exposed to its own set of risks. Increasing awareness and extensive coverage of erroneous decisions taken by senior executives (for example Satyam scam and sexual harassment cases in the year 2000) have also brought D&O liability insurance issues into the Indian board room. Further, the economic downturn along with a rise in sub-prime related law suits has brought an increased awareness of D&O insurance. Recently India, Inc. saw as many as 340 independent directors resigning from their positions fearing that their reputation might be at stake if the company fails to live up to investor expectations. The Satyam case brought to fore issues related to protection for independent directors and other innocent executives. I believe that Satyam was dubbed as the "Indian Enron" when it was revealed in January 2009 from the company’s founder and Chairman that more than $ 1 billion of revenues the company had reported were fictitious.

 

Earlier, many firms resisted the need for D&O insurance because of a less litigious environment and hence the assumption that they would never have a D&O claim. We believe that this perspective overlooked the fact that there are claims such as racial discrimination, sexual harassment and unfair dismissal which have resulted in regulators actions under various statutes, such as the Companies Act 1956, Securities and Exchange Board of India 1992, Foreign Exchange Management 1999 etc. Further, the reports on Corporate Governance such as the Kumarmangalam Birla report 1999; the Narayana Murthy Report 2003 and Clause 49 of the listing agreement with stock exchanges state explicitly the board’s responsibilities. These statutes set the standards for directorial behavior and at the same time increase the potential for actions against directors who fall short of these standards. In our view, actions can come from various D&O claims plaintiffs that include customers, vendors, employees, competitors, suppliers and a host of other stakeholders. In this globalized world, anyone anywhere can be a prospective claimant and when a company has a claim, costs can mount quickly. In such cases, suits with little merit can be also expensive to defend and resolve. There could be significant defense costs and damages in such actions which can vary from thousands to millions of rupees. The length of time taken to settle these cases can also extend from several months to several years.

 

Why sell D&O insurance in India?

 

The general awareness of D&O related liability risks amongst the Indian corporate sector and the financial services industry has given an opportunity to the Indian insurance industry to provide insurance solutions to cater to the need of their clients. This is evident in the number of the companies that offer D&O insurance. The leading companies in India that offer D&O insurance include Tata AIG, HDFC Ergo, Bajaj Allianz, ICICI Lombard, New India Assurance and Raheja QBE.

 

In our view, the Indian economy is expected to be in high single digit growth in the current decade. Indian companies are listing on foreign stock exchanges, acquiring or merging with non-Indian companies. The listing requirements, the litigious environment in overseas jurisdictions and the prohibitive legal costs all make D&O insurance a ‘must-get’ policy. Further, we believe that the risk of claims and litigation for the directors and officers of a company would continue to see a significant increase, both over the short and long-term as more Indian companies become globalized. There are companies in India that have taken maximum D&O cover ranging from $1 million to $100 million. Recently in a landmark development in the Indian insurance industry, Tata Steel purchased consolidated global cover (including its European operations) worth $160 million for its directors and officers. So most Indian multinational companies are buying or consolidating their D&O covers in India because of premium efficiencies, choice of the best-in class policy wordings, limits, deductibles and also because of close proximity with the insurance companies and intermediaries.

 

Currently most multinational companies already have D&O cover for their subsidiaries currently operating in India. This is imperative for them due to operational, working and cultural differences in each country’s environment. However, despite the increased awareness of D&O, the cover purchased by publicly listed companies in India is very limited with only 10% of listed companies having D&O policies of any sort. So there are advantages for insurance brokers and insurance companies to demonstrate the features of D&O cover (what should and shouldn’t be covered) to the management of publicly listed companies in India. The attitude amongst Indian entrepreneurs for purchasing an insurance cover was considered a cost rather than an investment with companies believing that they are unlikely to need the insurance because they believed that they would never have a lawsuit and moreover because of the less litigious environment. But we believe that with the Satyam scam, the sexual harassment in Infosys and other D&O related issues, the importance of having a D&O insurance cover would increase and as a consequence of this increased interest, the quality of D&O covers available in the market will improve.

 

Historically, Private companies in India resisted the need for D&O insurance as they felt the number of shareholders was minimal. However recently, more Indian privately-held companies with their share of employment disputes and minority shareholder issues are increasingly showing more interest in buying D&O cover. The fact is, the right time to buy insurance is when you think you don’t need it. Indeed the costs for private company D&O insurance is relatively low compared to publicly listed companies and for the relatively low cost, private company D&O insurance buyers can obtain coverage that is quite broad. Since private company D&O insurance policies provide broader coverage at a relatively low cost, we believe that D&O cover should be part of every private company’s risk management portfolio – not just private companies with a broad ownership base.

 

Regulation is also one of the strongest drivers for purchasing insurance in India. The fact that the Securities and Exchange Board of India (SEBI) intends to make D&O mandatory for publicly listed companies, is fueling demand for D&O insurance products. The purchase of management liability policies such as D&O liability is driven more by regulatory compliance and corporate governance rather than a risk management approach.

 

Lastly, we believe that the motivation for buying D&O cover does not rest solely upon factors such as financial misstatements, sexual harassment, etc. The possibility for litigation can also arise due to other genuine reasons. For example, although directors and officers have a duty of care to make decisions that are in the best interest of the organization and its stakeholders, there is always a risk of getting it wrong and being sued as a consequence. The possibility of litigation against individuals can result in an unwillingness on the part of boards to take risky decisions or actions as they can stand to lose a lot in the event of a legal challenge. As the management of Indian companies gain a broader understanding of the benefits D&O insurance, the demand for cover will most definitely increase.

 

Combined or Separate Limits?

 

The most popular cover across India within D&O liability is the Excess Side A Cover, which is the directors & officers own personal dedicated limit of liability, where they are not indemnified by the company. For example, D&O policies are often written to include coverage for lawsuits brought directly against the organization which has resulted in sharing policy limits among the organization and its directors, officers or members. In certain situations, the bankruptcy courts have seized the D&O policy as an asset of the bankruptcy estate, leaving the directors, officers or members without coverage. These policies are written with very few exclusions and will provide coverage on a primary basis where coverage is broader than the underlying primary D&O policy. Further, insurance buyers should ensure that small premium differences do not deter them when making important insurance decisions which could leave them vulnerable without sufficient protection should the hour of the need arise.

 

What to look for in the Proposed New Indian Companies Bill?

 

For the first time, duties of the directors have been defined in this bill. The bill states that the director of a company shall:

 

  • Act in accordance with its constitution document.
  • Act in good faith in order to promote the objects of the company for the benefit of its members as a whole and in the best interests of the company, its employees, the shareholders, the community and for the protection of environment.
  • Work with due and reasonable care, skill and diligence; exercising independent judgment
  • Not be involved in a position or activity that may be in a direct or indirect conflict of interest with company or possibility of conflict
  • Not take or attempt any undue advantage either personally or for relatives, partners or associates. If any director is found guilty for achieving undue gain, the director will be liable to reimburse an amount equal to the gain to the company
  • Cannot hand over his office and any such assignment shall be void

 

Besides this, the new proposed Bill CA2012 bill has widened the definition of the "officer who is in default" to include key managerial personnel that includes

 

  • Chief Executive Officer or the Managing Director or the Manager
  • The Company Secretary
  • The Whole-Time Director
  • The Chief Financial Officer; and
  • And such other officer which may be prescribed

 

The proposed Bill CA2012 has no provision corresponding to Section 201 of the CA1956 Act (indemnification of directors) stating that there is no restriction on the companies to indemnify its directors. The only reference to the provisions of indemnity to directors is given in Section 197 of the CA2012 stating that the premium paid on the insurance policy shall be treated as part of the remuneration of the officers only if such officer is found guilty. The critical distinction between Indian Companies Act 1956 and the proposed bill CA2012 is that insurance companies can now indemnify directors even before the judgment of the court. The advantage of this policy arrangement is that now directors or officers would not have to worry about defense costs. 

 

The proposed Bill CA2012 also introduces the concept of class action suits to provide that a requisite number of members or depositors may file an application before the Tribunal on behalf of the members and creditors if they are of the opinion that the management or control of company affairs are being conducted in a manner that is against the interests of its members or creditors.

 

Future Outlook for D&O Insurance in India

 

The landscape in India with respect to D&O insurance has changed rapidly in the last five years. We  believe that because of recent developments in D&O related issues, we have transitioned from concept selling to general awareness about the D&O product. Directors would want to shield themselves from the risk of huge liabilities in the event of fraudulent activity stemming from poor corporate governance policies. The surge in demand has been fuelled not just by recent high profile scandals but also due to higher judicial and regulatory scrutiny by the regulatory authorities. For example, there have been talks about the Securities and Exchange Board of India (Indian capital markets regulator) making it mandatory for all listed companies to buy D&O insurance. Further, the proposal to hike Foreign Direct Investment in Insurance to 49% is likely to be taken up in parliament for the budget session. If passed and ratified, capital would not be a limitation for expansion.

 

As more and more Indian companies become multinationals, and more foreign entities invest in them, companies employ people of various nationalities. So with this, the Indian D&O market is poised for a rapid growth. Companies, who want to deal with India, should note that currently, entry of Insurance Companies into India is permitted only through joint ventures, with FDI limits (Foreign Direct Investment).

 

In the latest of a series of decisions dealing with the enforceability of arbitration agreements, the U.S. Supreme Court in its 2011 decision in the AT&T Mobility LLC v Concepcion case held that the Federal Arbitration Act preempts state laws that refuse to enforce class action waivers in consumer arbitration agreements as unconscionable or against public policy.

 

The Concepcion decision has had a sweeping impact, as was seen most recently in a February 21, 2013 FINRA Hearing Panel decision in a enforcement action involving Charles Schwab & Company. The FINRA enforcement department had brought an action against Schwab challenging the company’s new customer agreement in which the customer was required to agree to arbitrate any disputes and waive any ability to assert a claim by means of a judicial class action. The Hearing Panel concluded that the agreement violated FINRA’s rules. However, it also concluded, in reliance on Concepcion, that the Rules are unenforceable because they conflict with the Federal Arbitration Act. (The Hearing Panel did find the agreement did violate the Rules by attempting to limit the powers of FINRA arbitrators to consolidate individual claims in arbitration.) FINRA has appealed the Hearing Panel ruling, but the Ruling does show the Concepcion decision’s significant impact.

 

And now, the question of the enforceability of arbitration agreements is back before the U.S. Supreme Court again. On February 27, 2013, the Court heard oral argument in yet another case examining the enforceability of arbitration agreements. The case is styled as American Express v. Italian Colors Restaurant. Background regarding the case can be found here. The case involves a purported class action antitrust action filed by a group of vendors against American Express in which the vendors allege that AmEx’s credit card policy constitutes an illegal tying arrangement because it forces the vendors to accept debit and credit cards at the same fee level.  American Express sought to invoke the arbitration clause in its contractual agreement with the vendors.

 

The case has been procedurally complicated and the specific decision on appeal to the Supreme Court represented the third separate opinion by the Second Circuit in the case. In what as known as the American Express III decision (here), the Second Circuit refused to enforce the class action waiver in the AmEx contractual agreement on the ground that it would effectively preclude the plaintiffs from prosecuting their federal antitrust claims because individual arbitrations would make the expert witness expense cost prohibitive.

 

 As a Ballard Spahr law firm points out in a memo about the case, the Third, Ninth and Eleventh Circuits disagree with the Second Circuit on whether or not the “vindication of statutory rights” theory is still viable in light of Concepcion. Those courts have found that Concepcion requires the enforcement of a class action waiver notwithstanding arguments that the plaintiffs would be unable to vindicate their statutory rights without a class action because their claims were worth less than the cost of litigating them.

 

The vendor plaintiffs’ were represented before the Supreme Court by former Solicitor General Paul Clement, who argued that it would not make economic sense for the vendors to pursue their claims individually because the costs of economic experts would be far in excess of their individual damages, and thus they would be effectively precluded from asserting their claims. As described in Daniel Fischer’s account of the oral argument in a February 27, 2013 Forbes article, the vendors’ contentions “did not seem to make much headway with the Justices.” Even liberal Justice Stephen Breyer expressed skepticism and lack of sympathy for the vendors.

 

The outcome of the pending Italian Colors case remains to be seen. But if as seems likely the Supreme Court continues to follow its now established pattern of supporting the enforceability of arbitration clauses, it seems likely that the vendors’ efforts to avoid AmEx’s arbitration clause, including the class action waiver, will fail. Of course, until the Supreme Court issues its decision in the Italian Colors case there is no way of knowing this for sure.

 

If American Express prevails in the Italian Colors case and the Supreme Court holds that the class action wavier in the AmEx customer agreement is enforceable, it raises the question of what may be next in the Supreme Court’s recognition of arbitration agreement and class action waiver enforceability. In particular it raises the question (that Daniel Fischer noted in his Forbes article) that the next step may be the question of enforceability of arbitration requirements in corporate articles of incorporation or by-laws.

 

The question of whether or not a company can impose an arbitration requirement through its articles of incorporation or its by-laws drew a great deal of attention when The Carlyle Group, which was preparing to go public at the time, specified in its partnership agreement that all limited partners would be required to submit any claims to binding arbitration. (I discussed Carlyle’s initiative in a prior blog post, here.) Ultimately, the SEC used its control of the registration process to prevent Carlyle from including this provision. But as illustrated in an April 22, 2012 article by Carl Schneider of the Ballard Spahr law firm on the Harvard Law School Forum on Corporate Governance and Financial Regulation (here), the idea continues to have its advocates and it seems likely that sooner or later there will be a case or circumstance testing the permissibility of arbitration provision in articles of incorporation or corporate by-laws.

 

For now, the questions of whether or not an arbitration clause in a corporate governance document would be enforceable will have to await another day. If the Supreme Court follows the trend of its own cases and upholds AmEx’s class action waiver in the Italian Colors case, we can certainly expect to see arbitration clauses with class action waivers proliferating in commercial documents. Unless and until Congress intervenes, arbitration provisions including class action waivers would likely become an increasingly common provision of transaction documents. Whether AmEx will prevail and whether that would lead to a test case involving articles of incorporation ad corporate by-laws remain to be seen. Until things change, it seems likely that we will all have to become increasingly more accustomed to dispute resolution through arbitration.

 

As I detailed in recent blog posts (here and here), these days virtually every public company M&A transaction is likely to involve M&A-related litigation. For that reason, M&A litigation represents a significant liability exposure for directors and officers of the companies involved in the M&A transaction and they have a keen interest in taking steps to try to reduce that exposure.

 

These concerns are the topic of a new paper from Chubb entitled “Director Liability Loss Prevention in Mergers and Acquisitions” (here). The paper was written by D&O maven Dan Bailey of the Bailey and Cavalieri law firm. (Readers know that The D&O Diary is a big fan of Dan’s; we recently published a guest post by Dan on Cyber Liability issues.) The paper “reviews the basic legal duties of directors in this context and summarizes many loss control procedures for directors when addressing a proposed M&A transaction.”

 

The paper notes at the outset that directors “are routinely rewarded” for their hard work on a proposed M&A transaction “by being sued.” The shareholder plaintiffs “typically allege the directors acted improperly in investigating, negotiating, approving, rejecting or disclosing the acquisition transaction, regardless of how thoroughly and prudently the directors acted.”  Though the lawsuits cannot be prevented, “directors can increase the defensibility of those lawsuits and improve the quality of their decision-making process with respect to a proposed acquisition by anticipating and implementing various loss prevention practices.”

 

The paper outlines the basic legal principles that define the standard of conduct for directors of the target company. The paper then goes on to outline the steps directors can take to try to manage their liability exposure. Among other things, the paper states that “directors should create a record demonstrating that they carefully and thoroughly considered relevant information regarding the proposed transact.” Directors should also “obtain advice from experienced, qualified and independent experts in each of the relevant substantive areas.” In addition, “only independent and disinterested outside directors should act on behalf of the company with respect to the proposed transaction.” In addition, “directors should seek to obtain the best value available for the company,” in the specific ways that the paper enumerates. Finally, the company must manage the timing and content of its disclosures of the transaction in order to try to minimize disclosure-related risks.

 

There are also a number of transaction-related pre-litigation strategies the company can implement to improve the companies ability to defend the inevitable litigation. These include, among other things, amending the by-laws to designate a specific jurisdiction as the exclusive venue for shareholder suits involving governance issues; retaining qualified defense counsel in advance of the transaction; develop an external communication protocol to reduce disclosure –related risks; and the provision of detailed directors training in anticipating of the takeover process, including the “likely sequence of events, recommended governance practices and various best practices related to the proposed transaction.”

 

Finally, the paper reviews the indemnification and insurance issues relevant in the M&A context.  Among other things the paper discusses the need for the target company to have in place prior to the closing “a prepaid, noncancelable, extended run-off policy that cannot be amended or affected in any way by the acquiring company or subsequent management.”

 

Another M&A related insurance topic that the paper does not discuss is the possible need for representations and warranties insurance protection. Readers may be interested to note that the Professional Liability Underwriting Society (PLUS is hosting a webinar on Tuesday March 19, 2013 at 11:00 am EDT on the topic of Representations and Warranties insurance coverage. Information about this free webinar can be found here.

 

D&O Year in Review: Once again, my good friends at Troutman Sanders have published their annual roundup of D&O insurance coverage decisions. The publication, which is entitled “D&O Professional Liability: A Year in Review,” which provides a comprehensive overview of coverage decisions from the world of D&O in the last year, can be found here.

 

Board Minutes: I recently was asked to attend a meeting of the board of directors of a large financial institution client. While I was in the meeting, one director asked my views about board meeting minutes: should the board minutes be very detailed? Or should they be bare-boned? Which was better from a risk management standpoint? From the way the director asked the question, I knew that that was a topic on which he himself had strong views, and his manner also suggested that this topic was an issue of some debate at the board level. I looked across the table to the company’s general counsel, to see how I should handle the question. Her face said “Don’t throw me under the bus.” So all I said was that the question of board minutes is an important topic that should be discussed with your in-house counsel and if needed your outside counsel.

 

The question about the appropriate level of detail in board minutes is a recurring question. There is, in fact, no single right answer. The correct answer will vary, depending on the age and size of the company, as well as the advice of the company’s counsel. There are a number of important considerations to keep in mind, which are reviewed in a March 6, 2013 JD Supra Law News article written by Stephen Honig of the Duane Morris firm and entitled “Director Liability: Corporate Minutes as Trojan Horse” (here). The article reviews the liability issues that may arise from the board minutes and also reviews how the ground rules change as companies mature and grow larger. The article reviews the legal touchstones and lays out the basic ground rules. The article concludes by saying that directors “should remember that they are protected if they utilize robust process in the board room and are well-served if they document that process.”

 

Is a Pending Appellate Decision Interpreting Morrison Off the Docket?: For some time, we have been awaiting a ruling from the Second Circuit in the hedge fund claimants’ appeal of a district court dismissal of their action against Porsche and certain of its directors and officers. The hedge funds, which had shorted Volkswagen stock in the belief that its share price would fall, claimed that Porsche misled investors by denying through much of 2008 that it intended to acquire VW. Porsche later disclosed that it had been positioning itself to acquire the company.

 

As discussed here, in a December 30, 2010 ruling, Southern District of New York Harold Baer granted the defendants’ motions to dismiss. In granting the motion, Baer relied on the U.S. Supreme Court’s decision in National Australia Bank v. Morrison. Judge Baer found that because the securities underlying the swap instruments the hedge funds had acquired were traded on the German stock exchange, acquiring the swaps was the “functional equivalent of trading the underlying shares on a German exchange."

 

The hedge funds filed an appeal of Judge Baer’s dismissal. As discussed here, while the appeal was pending, the Second Circuit issued a ruling in the Absolute Activist Value Master Fund case interpreting Morrison’s application to non-exchange traded securities. The court held that in order to pursue a securities claim in connection with a transaction in non-exchange securities, the claimant has to allege either “irrevocable liability was incurred or title transferred within the United States.” I noted at the time that the Absolute Activist Value Master Fund case The Second Circuit’s holding in the Absolute Activist Value Master Fund case, in which the Second Circuit said among other things that the identify of the securities involved in the transaction is not determinative, would seem to suggest that the district court’s holding in the Porsche case may not withstand scrutiny on appeal.

 

Ever since the Second Circuit issued its ruling in the Absolute Activist Value Master Fund case, observers have been awaiting the Second Circuit’s ruling in the Porsche case. However, on March 6, 2013, Bloomberg reported (here) that the hedge funds have filed a motion to withdraw their appeal in the Porsche case. The Second Circuit must grant the motion to withdraw, but assuming it is granted, it appears that the appeal would be withdrawn, meaning that the lower court dismissal of the case would stand. The Bloomberg article notes that four cases against Porsche and certain of its directors and officers remain pending in Germany. It appears that the hedge funds may have decided to focus their efforts on the Germany cases.

 

In any event, if the Second Circuit grants the motion to withdraw, the long-anticipated resolution of the hedge funds’ appeal of the dismissal will not be forthcoming. That would mean at a minimum that the Absolute Activist Value Master Fund ruling will continue to represent the standard for securities cases involving non-U.S. entity defendants whose shares do not trade on U.S. exchanges.

 

I can’t help having a “that’s too bad” reaction. I have been looking forward to seeing what the Second Circuit was going to do with the appeal in the Porsche case.

 

One Director Defendant in Latest FDIC Failed Bank Suit: As the FDIC has been ramping up its litigation against the directors and officers of failed banks, one of the things that has been hard to figure is how the agency decides who it is going to sue. Sometimes it files cases only against former bank officers, sometimes it includes director defendants. And now in the latest case to be filed, the FDIC has filed a suit against only a single director defendant. However, in this case, there is some information available to explain why the one director was the only defendant.

 

On February 22, 2013, the FDIC, acting in its capacity as the receiver of the failed Carson River Community Bank, filed an action in the District of Nevada against James M. Jacobs, a former director of the bank. A copy of the FDIC”s complaint can be found here. Regulators closed the bank on February 26, 2010, which means that the agency filed its compliant just before the third-year anniversary of the bank’s closure. The sole defendant is described in the complaint as the co-founder and as a stockholder of the bank, as well as a director in the bank. Importantly for purposes of the suit, the complaint also states that Jacobs also had ownership interests in certain Oklahoma banks that participated in some of the loans that the FDIC referenced in the complaint.

 

As detailed in a March 1, 2013 memo by W. Bard Brockman of the Bryan Cave law firm (here), according to the FDIC’s complaint, the three subject loans were participated out to two Oklahoma banks owned by Mr. Jacobs’ family and for which Mr. Jacobs served as a director. The other directors on the Senior Loan Committee knew about Mr. Jacobs’ interest in the participating banks, but they did not know that Mr. Jacobs allegedly had secretly arranged for the Oklahoma participating banks to have preferential rights to repayment upon default. The Oklahoma banks were ultimately paid in full and Carson River Community Bank sustained most of the loss on the loans. This conduct, the FDIC alleges, constituted a breach of Mr. Jacobs’ fiduciary duty to Carson River Community Bank.

 

Brockman speculates that there may be an additional reason why the other loan committee members were not named as defendants because “Nevada has a very forgiving standard of liability for corporate directors. Under the Nevada corporate code, a director is not liable unless it is proven that: (a) the director’s act or failure to act constituted a breach of his fiduciary duties; and (b) the breach of those duties involved intentional misconduct, fraud or a knowing violation of law.” Brockman suggests that the FDIC must not have had sufficient facts to support an allegation that the other directors had committed “intentional misconduct, fraud, or a knowing violation of the law.” Brockman concludes by noting that this case is “a true factual outlier and it does not signal a trend that the FDIC will target single director defendants.”

 

A Break in the Action: For the next few days, I will be traveling overseas on business. The D&O Diary’s publication schedule (such as it is) will be disrupted for the next few days. I hope to resume the normal publication schedule during the week of March 18, 2013.

 

And Finally: A recurring topic of interest to everyone here is the question of why The Netherlands is sometimes referred to as Holland. This topic is amusingly explained in the accompanying video (with more information on the topic than you might have thought possible). Enjoy. (Sorry about the short commercial at the beginning.)

 

Although I was aware that among the Dodd-Frank Act’s hundreds of pages are provisions relating to so-called “conflict minerals,” until recently I had not had to pay much attention to these provisions. But now, for whatever reason, the conflict minerals disclosure requirements suddenly have hit the center of my radar screen. I have had to do a lot of backing and filling on the topic. Because I think we are all going to have to become familiar the conflict mineral disclosure requirements, I have summarized what I have learned below

 

First, some background. Section 1502 of the Dodd Frank Act required the SEC to promulgated rules requiring companies to annually disclosure their of conflict minerals originating in the Democratic Republic of Congo (DRC) or an adjoining country. On August 22, 2012, the SEC adopted the conflict mineral disclosure rules. The SEC’s August 22, 2012 press release can be found here and the rule itself can be found here.

 

The specific minerals at issue are tantalum, tin, tungsten and gold. The countries covered by the disclosure rules are, in addition to the DRC, Angola, Burundi, Central African Republic, the Republic of Congo, Rwanda, South Sudan, Tanzania, Uganda and Zambia (the “Covered Countries”)

 

The rule applies not just to companies with SEC reporting obligations (including both domestic and foreign issues) but. It also applies to any company that uses the specified minerals if the minerals are “necessary to the functionality or production” of a product manufactured by or “contracted to be manufactured” by the company.

 

Companies are required to comply with the new disclosure rules for the calendar year beginning January 1, 2013, with the first disclosures due May 31, 2014 and subsequent disclosures due annually each year after that. However, a legal challenge to the rules has been raised. On October 19, 2012, the U.S. Chamber of Commerce and the National Association of Manufacturers filed a petition for review with the Court of Appeals for the District of Columbia requesting that the SEC’s rule be set aside in whole or in part.

 

While the legal challenge remains pending, many companies are readying themselves to comply with the rule. Basically, the rule requires disclosure by a public company if it manufactures (or has others manufacture) a product that includes a conflict mineral. If a company determines that its product has a conflict mineral, the company must conduct a good faith inquiry to determine if the mineral is derived from mining in one of the Covered Countries. If the company determines that the minerals came from one of the Covered Countries, it must then file a Conflict Minerals Report on Form SD.

 

Among other things, companies filing a Report must conduct due diligence efforts (using an internationally recognized framework, such as the OECD Due Diligence Guidance) to determine whether the operations in the Covered Country helped finance armed conflict. If the minerals are conflict free, the company must certify that conclusion with an independent audit. If the minerals are not conflict free, the company must disclose the information relating to its use of the conflict minerals. For companies unable to determine whether or not the minerals are conflict-free, the company can declare itself “conflict indeterminable” during a two-year grace period (four years for smaller reporting companies).

 

Notwithstanding the legal challenge, and though the first reporting deadline is still more than a year away, many companies are now scrambling to try to adapt to these reporting requirements. As Barbara Jones of the Greenberg Traurig firm wrote in a March 5, 2013 Law 360 article entitled “Sharpen Your Pencils for Conflict Minerals Disclosures” (here, registration required), reporting companies are “forming high-level internal compliance teams with representatives from legal, finance, internal audit and purchasing involved to assess the extent, if any, that the company’s product contain conflict minerals.” The efforts, she notes have extended to “supply chain participants” who are not “deeply involved in determining and certifying the original source of supplies of tantalum, tine, tungsten and gold (3TGs) and their numerous derivatives, sold to their customers.”

 

There is a lot of risk here for the companies involved. First and foremost, companies face a serious potential PR risk. Companies found to be out of position on conflict minerals will undoubtedly face a publicity firestorm from humanitarian groups and activist investors. Although it remains to be seen, adverse publicity could prove to be a problem not just for companies that must declare their use of conflict minerals but even for those that are unable to declare themselves conflict mineral free.

 

As with any disclosure requirement, there is also a significant litigation risk as well. Companies compelled to reveal their use of conflict minerals could well be the target of shareholder suits. A particularly difficult problem would involved companies that had declared themselves to be conflict free that are later shown have been using conflict minerals after all. The negative publicity and likely share price decline would undoubtedly be followed by a securities class action lawsuit. Activist shareholders could also launch derivative suits against companies based on allegations such as the failure to implement adequate procedures to ensure that the company’s products were conflict mineral free.

 

Of course, whether any of these kinds of suits actually emerge remains to be seen. But though these potential dangers remain off in the future, and though the first reporting deadline is more than a year ahead, the present challenge for reporting companies is to be prepared now for these coming tests. I also anticipate that in coming months, questions surrounding companies’ preparations for the conflict minerals disclosure requirements increasingly will become a part of the D&O insurance underwriting process.

 

As a final note, I should stress that in my description above I simplified the conflicts minerals disclosure requirements. Readers who want a deeper understanding may want to visit the Conflict Minerals Resource Center on the website of the Schulte Roth law firm. The site has a number of helpful links and articles.

 

Many organizations purchase management liability insurance to provide liability and defense cost protection for their directors and officers. But the management liability insurance protects the individuals only for their actions undertaken in an “insured capacity.” The policies are not intended to not protect them for actions they undertake in a capacity other than as a director or officer of the organization. These issues proved to be determinative in the action to decide whether or not D&O insurance issued to Jerry Sandusky’s organization, The Second Mile, covered the legal fees Sandusky incurred defending criminal and civil allegations involving misconduct with children.

 

In a March 1, 2013 Memorandum Opinion, Middle District of Pennsylvania Chief Judge Yvette Kane held that because the alleged misconduct did not arise in Sandusky’s capacity as an employee or executive of The Second Mile, the organization’s management liability insurer had no obligation to provide him defense cost coverage. A copy of Judge Kane’s opinion can be found here. As I note below, I have some concerns about this ruling.

 

Background

Sandusky founded The Second Mile in 1977. From 1977 until Sandusky was criminally indicted for offenses against children. Sandusky served at times as a volunteer and at times as an executive-level employee of the organization. In November 2011, a grand jury returned a report charging Sandusky with multiple crimes involving children. Following a trial, Sandusky was convicted of a total of 45 charges involving offenses against children. Sandusky has appealed his criminal conviction. Sandusky has also been named as a defendant in a separate civil proceeding brought by one of his alleged victims.

 

Sandusky sought coverage for the attorneys’ fees incurred in both the criminal and civil matters from The Second Mile’s management liability insurer. Sandusky sought coverage under both the D&O and EPL portions of the policy. The insurer advanced Sandusky’s defense expenses subject to a reservation of its rights under the policy and initiated an action seeking a judicial declaration that it had no obligation to fund Sandusky’s defense expenses. The insurer filed a motion for judgment on the pleadings, arguing that it would be against Pennsylvania public policy to indemnify Sandusky for the child molestation charges against him. As discussed here, in a June 2012 order, Judge Kane agreed that it would be against Pennsylvania public policy for the insurer to indemnify Sandusky, she reserved the question of whether it would be against public policy for the insurer to provide Sandusky with a defense.

 

After Sandusky’s criminal conviction, the insurer moved for summary judgment, arguing that the acts alleged against Sandusky were not undertaken in an insured capacity. The policy defined the term “Insured Capacity” to mean “the position or capacity of an Insured Person that causes him to meet the definition of Insured Person.” Sandusky argued that the meaning of this provision is ambiguous and the further discovery was required to determine the extent of the coverage provided under the policy. 

 

The March 1 Opinion

In her March 1, 2013 memorandum opinion, Judge Kane granted the carrier’s motion for summary judgment. She found the policy language regarding “Insured Capacity” to be “unambiguous.” She said that in order to determine “whether the actions that form the basis of the claims against Defendant were performed in his capacity or role as an executive or employee of The Second Mile,” she must review the allegations against him. She then reviewed the various abuse allegations that had been alleged against Sandusky. Among other things, she noted that the alleged abuse was alleged to have taken place in a variety of locations, all away from The Second Mile’s facilities.

 

Based on this review, she concluded that “it is clear that Defendant Sandusky was not acting in his capacity as an employee or executive of The Second Mile in sexually abusing and molesting the victims named in the criminal and civil cases brought against him, and the Court so finds.” She added that Sandusky was not alleged to have engaged in the alleged misconduct “in furtherance of his duties for The Second Mile.” She noted that the fact that Sandusky met his victims through The Second Mile or even that he sexually abused victims “during the course of activities at” The Second Mile “does not change the fact that his sexual abuse of children was personal in nature and performed in his individual capacity.” Because Sandusky’s alleged conduct “was clearly personal in nature and not in furtherance of his duties for The Second Mile, he is owed no criminal defense under the Policy.”

 

Discussion

The nature of these allegations is so repugnant and the fact that Sandusky has been convicted criminally makes it hard to spend any time thinking about the issues here. I certainly have no interest in defending Sandusky or trying to prove that he has not been dealt with fairly here.

 

Nevertheless I do have concerns about this ruling. It is easier to see my concerns if we forget about Sandusky and imagine instead that a volunteer or employee of a nonprofit organization has been unfairly targeted by abuse allegations, perhaps as a particularly vindictive part of a smear campaign. Let us say for purposes of this hypothetical that the allegations, though false, are otherwise as heinous as those against Sandusky.

 

My concern is that under Judge Kane’s ruling, even this falsely accused individual could not look to his origination’s management liability insurer for a defense. Her ruling does not depend on Sandusky’s conviction. She expressly says that “Sandusky’s offenses against children –whether proven or alleged – were not conduct in his capacity as an employee or executive of the Second Mile.” The allegations alone are enough to determine coverage, because “sexual abuse of children” is “personal in nature” and is “performed in individual capacity.” She even said that this conclusion would apply “even if he sexually abused victims “’during the course of activities of Second Mile.’” 

 

If the mere fact that allegations of sexual abuse are personal and individual is enough to preclude coverage for Sandusky, then are mere allegations sufficient to preclude coverage even for a nonprofit official who is falsely accused as part of a smear campaign? Keep in mind, Kane is not interpreting a clause of a policy in which the insurer says “we won’t insure even allegations of sexual molestation.” She was interpreting a clause that talks about the capacity in which a person was sued and for which he or she got sued. In our smear campaign hypothetical, the only reason my hypothetical smear campaign individual was targeted was because they were an official of the nonprofit. Are we prepared to say that this falsely accused individual is under no circumstances entitled to a defense, simply because of the nature of the allegations?

 

I would be much more comfortable all the way around with this decision if it were based on the fact that Sandusky was actually convicted. Of course, given that his criminal case is still on appeal the judgment in the criminal case is not final, and so the insurer might not be able to preclude coverage on the basis of the criminal conviction for some time yet.

 

When Judge Kane says that her conclusion that Sandusky was not acting in an insured capacity applies even though he allegedly abused victims “during the course of activities of Second Mile,” that’s when I get uncomfortable with this result. It would be very easy to shrug this result off because of the terrible things for which Sandusky was convicted. But because Judge Kane’s conclusion does not depend on the conviction, this same result could apply to any nonprofit official, even one who is falsely accused and would otherwise be forced to defend him or herself against outrageous allegations without insurance and at their own expense. I am very uncomfortable with this whole subject matter, but I am also not entirely comfortable with this decision.

 

I invite readers to weigh in on this topic, particularly those who take a different point of view on this decision than I do. (I know I am setting myself up for a raft of messages about the need for separate sexual molestation coverage or the possible problems with the bodily injury exclusion in the typical D&O insurance policy, and perhaps other similar arguments as well. Please bear in mind that my concerns here are focused exclusively on Judge Kane’s reasoning in denying coverage, not on whether there may be other questions that might affect coverage or whether there are alternative insurance arrangements that might better address the sexual molestation exposure.)

 

Whistleblower Watch: In my annual year-end round up of D&O insurance and liability issues, I more or less said that I thought 2013 would be the year of the whistleblower, or at least the year in which the whistleblower bounty provisions of the Dodd Frank Act kick into high gear. Well, here we are into the third month of 2013, and there still haven’t been any more whistleblower bounty awards. So was I wrong? Maybe I was, but before you decide, you need to take a look at the list that Mary Jane Wilmoth has been compiling over at the Whistleblower Protection Blog.

 

As Wilmoth reports, the SEC posts Notices of Covered Action when a final judgment order, by itself or with prior orders and judgments in the same action, results in monetary sanctions over $1 million. Individuals who voluntarily provided the SEC original information that led to successful enforcement in the actions identified in the Notices are eligible to apply for whistleblower awards. Once the Notices are posted, individuals have 90 days to apply for an award. The blog post lists 22 actions in which Notices have been posted. The list is complete through February 8, 2013. From looking at the dates on which the Notices have been posted, the SEC is putting up Notices regularly. The pretty clear inference is that this list is going to get a lot longer very rapidly.

 

Obviously not all of the Notices will lead to whistleblower bounty awards. Indeed, many will not, as there may not be a qualifying individual. But it seems highly probable that there will be some awards, perhaps many. In other words, it still seems possible that 2013 will be the year in which whistleblower bounty provisions kick into high gear. Stay tuned.

 

The modern public company D&O insurance policy provides coverage not only for the directors and officers of the company but also for the company itself – however, in the public company D&O insurance policy, the entity coverage applies only to securities claims, a limitation that sometimes leads to disputes whether or not a particular matter constitutes a securities claim.

 

A recent decision from the Central District of California took a look at whether the claims against a mortgage originator and securitizer involving the company’s issuance of mortgage-backed securities constituted a “Securities Claim” within the meaning of the company’s D&O insurance policy. In her February 26, 2013 order (here), Judge Josephine Tucker held that the claims were not “Securities Claims” within the meaning of the D&O policy and therefore that the insurer did not have a duty to advance defense costs.

 

Background

Until 2007, Impac Mortgage Holdings funded, sold and securitized residential mortgages. A unit of the company acquired mortgages that another company unit originated. The acquired mortgages were placed in a trust, which in turn issued certificates that were issued to an underwriter which then sold them to investors.

 

The coverage dispute relates to three separate claims that were asserted against Impac and its related entities. First, in April 2011, the Federal Home Loan Bank filed a state court complaint against Impac alleging unfair and deceptive acts as well as false and misleading statement in connection with the sale of the certificates. Second, in May 2011, Citigroup filed an action in the Central District of California against Impac, alleging violations of Sections 18 and 20 of the Securities Act of 1934, as well as negligent misrepresentation in connection with the Citigroup’ s purchase of certain other certificates. Finally, in April 2010, the Federal Reserve Bank of New York sent a letter to Impac referencing a dispute concerning priority of payments under four Impac securities offerings.

 

Impac submitted all three of these matters to its D&O insurer, seeking to have the insurer advance defense costs for all three matters and contending that all three arose out of Impac’s mortgage-backed securities business. The insurer denied coverage for all three claims and Impac filed an action against the D&O insurer, seeking a judicial declaration that the insurers ha a duty to advance defense costs. The parties cross-moved for summary judgment.

 

In pertinent part, the D&O insurance policy defined the term “Securities Claim” to mean a claim made against an insured:

 

(1) alleging a violation of any federal, state, local or foreign regulation, rule, or statute regulating securities …which is

(a) brought by any person or entity alleging, arising out of, based upon or attributable to the purchase or sale of or offer or solicitation of an offer to purchase or sell any securities of an Organization;

 

The February 26 Ruling

In her February 26, 2012 order, Judge Tucker denied Impac’s motion for summary judgment and granted the D&O insurer’s summary judgment motion.

 

The D&O insurer had argued that the phrase “securities of the Organization” in the policy’s definition of the term “Securities Claim” referred to Impac’s own securities. Impac urged that the phrase had an additional meaning extending it to the mortgage-backed securities at issue in the underlying disputes. Impac argues that the term securities “of” the company encompasses securities that were possessed, connected or associated with the company.

 

With respect to Impac’s interpretation of the definition, Judge Tucker said:

 

The fact that it would be “semantically permissible” to interpret the Policies’ language as extending coverage to securities Impac bought, sold or was involved in the creation of is not sufficient to create coverage where none would otherwise exist. Rather the court must interpret the disputed language in context, w with regard to its intended function in the policy. Here, Impac has provided no admissible evidence that such an interpretation gives effect to the mutual intention of the parties. (Citations omitted)

 

Judge Tucker went on to note that Impac’s proposed interpretation “would require the phrase ‘securities of’ to carry multiple meaning within one policy definition.” She added that in the context of the full definition and policy, “the phrase ‘securities of’ makes sense only in reference to the securities of Impac itself.” She added that by ascribing multiple meaning so the phrase, “Impac’s construction would result in the provision of vastly broader coverage when the insured happens to engage in the business of securitizing mortgages and would cause a traditional D&O Policy for those particular companies to become a defacto E&O policy, i.e., a professional liability policy for entities.”

 

Judge Tucker also concluded that coverage was precluded by the D&O policy’s Error and Omissions Exclusion, precluding coverage for the company’s “performance of (or failure to perform) any professional services.” She noted in that regard that Impac had asserted against the co-defendant in the action – that is, Impac’s E&O insurer – that the underlying claims do arise out of the provision of professional services.

 

While she concluded that coverage was precluded under the D&O policy’s Errors and Omissions exclusion, Judge Tucker did rule in Impac’s favor ruling in a separate February 26, 2013 order (here) in Impac’s separate action against its E&O insurer. She held that that Impac’s securities transactions constituted professional services under the E&O policy. The parties had disputed whether the underlying claims, which related to Impac’s securitization of mortgages, arose out of Impac’s “performance of or failure to perform professional services for others.” The E&O policy defined Impac’s profession as “mortgage banker/mortgage broker.” Judge Tucker concluded that “the undisputed facts support the conclusion that the securitization was a central element in Impac’s mortgage banking/brokerage business.”

 

She also found that an exclusion cited by Lloyd’s was too ambiguous to warrant a denial of coverage. (The exclusion on which the E&O insurer had sought to rely excluded coverage for (1) “the depreciation (or the failure to appreciate) in value of any investment transaction” or (2) “any actual or alleged representation, advice, guarantee or warranty provided by or on behalf of an Insured with regard to the performance of any such investment.”)

 

Discussion

Like many coverage disputes, the dispute here over whether or not the claims at issue were or were not “Securities Claims” came down to an interpretation of the specific policy language at issue. But even without reference to the specific provisions in the policy, it would have represented an unexpected result for a company’s D&O insurance policy to pick up coverage for claims brought against it for its activities as a mortgage securitizer. As Judge Tucker correctly concluded, to do so would require the D&O insurance policy to provide coverage for the company’s delivery of professional services and would thereby convert the policy into an E&O insurance policy – when in fact the D&O policy carried an express exclusion of coverage for claims arising from the delivery of or the failure to deliver professional services.

 

In a Monday morning quarterbacking kind of a way, I find it irresistible to note that the extent of the policy’s coverage would have been clearer if the policy had not only generally excluded coverage for claims arising from the delivery of professional services but also expressly precluded from the definition of securities claim the company’s issuance of securities as part of its business as a mortgage securitizer.

 

While I don’t have a problem with Judge Tucker’s interpretation of the policy here, there are other gray areas that arise from time to time with respect to the extent of D&O insurance coverage for securities claims. There are claims that can arise when a company is hauled into a lawsuit alleging violations of the securities laws when the specific securities at issue may not be those of the insured company.

 

A couple of examples come to mind: say, for example, when the insured company has spun out one of its divisions as a stand alone, publicly traded entity, and the separate entities file claims not only against the new company but out of the predecessor firm as well. (For an example of this kind of claim, refer here). Another example is an aiding and abetting type lawsuit; say, for example, an insured company is alleged to have violated the securities laws by aiding another company misrepresent its financial condition (sure, private claimants can’t assert these kinds of claims under the federal securities laws, but the SEC can, and private claimants could assert their claims in reliance on state law liability theories). A D&O insurance policy limiting “Securities Claims” solely to claims relating to securities “of” the company arguably might preclude coverage for these claims. For that reason, I have preferred definitions of the term “Securities Claim” that extends coverage to any claim alleging a violation of the federal securities laws or state or local equivalents.

 

From the factual allegations in the Impac case, I can now see (from the carrier’s perspective), at least one flaw with a definition of the term “Securities Claim” that would extend coverage to any alleged violation of the securities laws. If Impac’s D&O policy had included this “any violation of the securities laws” formulation, the policy might well have picked up coverage for the claims against Impac arising from its mortgage securitization activities, which is a result I am certain that the D&O insurer did not intend here.

 

Recognition of this potential shortcoming to the “any violation of the securities laws” formulation suggests a need to devise a new formulation, one that would not hazard the kind of unintended result I noted in the preceding paragraph. My current thought is that perhaps the “any violation of the securities laws” formulation could include a provision expressly precluding coverage for the company’s issuance of securities other than its own securities.

 

This is the kind of topic that I think would benefit from a more thorough discussion. I welcome readers thoughts on this topic, under the heading – “toward a more perfect definition of the term ‘Securities Claim’.”

 

One final note for practitioners. In her analysis of the D&O policy, Judge Tucker correctly determines that traditional “duty to defend” case law and policy interpretation principles do not apply to a “duty to advance” D&O insurance policy. Those involved in litigating defense expense issues in the context of a D&O insurance policy may find her discussion of these issues useful.

 

A Stray Thought about Current Events: Pope Benedict has now moved on to his new life as Pope Emeritus. He undoubtedly hopes he can look forward to a life of quiet contemplation. Everyone here at The D&O Diary wishes him well. Whatever may lie ahead for him and for the Catholic Church, we can all be sure that Benedict will avoid the fate of one of his predecessors, Pope Formosus, who died in April 896 at the age of eighty-one after a five year papacy.

 

As described in Paul Collins’s recent book, The Birth of the West, a one-volume history of the nascent beginnings of modern Europe in the Tenth Century, following the death of Pope Formosus, his successor, Pope Stephen, convened what has become known as the “Cadaver Synod.” Ten months after Pope Formosus died, and under pressure from local magnates, Pope Stephen had his predecessor’s corpse exhumed, dressed in pontifical robes, and placed in a bishop’s chair to be tried for heresy. With troops surrounding the city, the terrified bishops called to pass judgment quickly found Formosus guilty of violating church law. All of his papal acts were declared void and his dead body, stripped of the papal robes, was reinterred as a layman in unconsecrated ground.

 

If Pope Stephen hoped this macabre ceremony would preserve peace, he was mistaken. Collins notes that “the Cadaver Synod marked the beginning of some of the worst internecine civil strife in the history of papal Rome.” All of this took place at a time when Europe was beset with recurring invasions from Vikings, Magyars and Saracens.

 

For those who are worried that the current Catholic Church faces challenges, well, things have been worse. Yet it was from this chaos that the rudiments of modern Europe slowly emerged. In any event, here’s hoping that the upcoming papal transition be smoother than some of those in the past have been.

 

Speaker’s Corner: On March 19, 2013, I will be speaking at a panel at the C5 Forum on D&O Liability Insurance in London. I will be participating on a panel entitled “The Impact of Increased Regulatory Oversight and Regulatory Investigations.” The panel will include my good friends Helga Munger of Munich Re, Cristiana Baez-Safa of XL and Ralf Rebetge of Chubb. The C5 Forum, which is excellent every year, includes a number of interesting sessions and an outstanding line up of speakers. Conference information, including registration instructions, can be found here. If you are planning on attending, I hope you will make a point of greeting me at the conference particularly if we have not previously met.

 

After market close on Friday, March 1, 2013, Warren Buffett delivered his annual letter to Berkshire shareholders. Buffett’s letters are widely read and closely studied for the insights he provides into the financial markets and into his own investment views. However, the most striking aspect of this year’s letter may be the topics he does not address. (Full Disclosure: I own BRK.B shares).

 

That is, despite Buffett’s age (82) and his recent health issues (in April 2012, he was diagnosed with stage 1 prostate cancer), Buffett does not address succession planning (except perhaps indirectly, as noted below). Despite the gridlock in Washington and the continuing difficulties in the Eurozone, Buffett does not directly discuss macroeconomic issues. Nor does this year’s letter include a marketplace critique, by contrast to recent years’ letters in which he has, for example, addressed the questionable value of investing in gold, potential problems with the dollar, or problems with the hedge fund business model.

 

What did Buffet talk about instead? Newspapers. Yes, newspapers.  Excluding Buffett’s description of the upcoming Berkshire shareholders’ meeting, the letter is eighteen pages long. Buffett devoted three pages – more than 16% of the entire letter — to newspapers. To be sure, Berkshire has purchased 28 daily newspapers in the last 15 months, but the total cost of these acquisitions is $344 million. Let’s put that into perspective. At year end, Berkshire had assets of $427.4 billion.

 

Why did Buffett devote so much of his letter to such a small part of Berkshire’s holdings? My theory is that it is a guilty conscience. He acknowledges at the outset that Berkshire’s newspaper acquisitions “may puzzle you” – not only because the newspaper business as a whole is in decline, but (more importantly) because the newspapers acquired “fell far short of meeting our off-stated size requirements for acquisitions.”  (Not only that, but Buffett famously stated four years ago that, despite Berkshire’s long-standing investments in the Washington Post and the Buffalo News, he would not buy a newspaper at any price.)

 

Buffett knows he has been straying from his own principles in acquiring the newspapers. He tries to justify all of this in a 23-paragraph defense, but the overly-long explanation fails to provide a single convincing reason why he would disregard his “oft-stated” principles to invest in an industry that he acknowledges is in decline.

 

In my view, Buffett acknowledges the real reason for the newspaper acquisitions at the outset, when he acknowledges that “Charlie and I love newspapers.” (Those readers who have read any of Buffett’s many biographies know that he was a paper boy for the Washington Post while his father served in Congress.) Buffett’s long defensive explanation for the newspaper purchasers reads to me like the product of a guilty conscience Buffett makes it clear that he intends to continue to purchase newspapers – but only, he emphasizes in italics “if the economics make sense.”

 

Another topic Buffett addresses is the question of dividends – as in, when will Berkshire start paying them? He acknowledges that shareholders frequently ask him about dividends, and he notes that it “puzzles them that we relish the dividends we receive from most of the stocks that Berkshire owns, but pay nothing ourselves.” Anyone hoping that this prelude was the lead-in of an announcement that Berkshire is now about to pay dividends was sure to have their hopes dashed. In a lengthy, arithmetic-intensive exegesis, Buffett, in a schoolmaster role that he seems to relish, illustrates from a purely financial standpoint how Berkshire’s shareholders are better off (particularly from an after-tax point of view) if Berkshire retains and reinvests its earnings rather than paying them out in dividends. It is a masterful job.

 

The only thing that is missing from the lesson is an explanation of why he invests in so many dividend-paying companies himself. Surely if refraining from paying dividends really is better for Berkshire’s shareholders, why isn’t that true for shareholders of Coca-Cola, Wells Fargo and so on? Perhaps anticipating this concern, Buffett concludes his homily on dividends with a very brief and somewhat disconnected observation that companies should be clear and consistent about their dividend policy. He notes that he “applauds” the practices of many companies to pay consistent dividends while trying to increase them annually. 

 

Let me put it this way: if I were allowed to ask Buffett a question at the Berkshire shareholders’ meeting in May, I would refer to this portion of his letter and then tell him I don’t understand why retained earnings are in Berkshire’s shareholders’ interests, but annually growing dividend levels are in the interests of the shareholders of the companies in which Berkshire invests. (If possible, an explanation that doesn’t require the use of slide rule would be appreciated.)

 

I won’t get to ask that question, so I will content myself with noting that there is another very important reason that Buffett doesn’t want Berkshire to pay a dividend; given his ownership interest in the company, a Berkshire dividend would be a huge taxable event for him. I don’t think I am going out on a limb by saying that as long as Buffett is around, there will never be a Berkshire dividend.

 

Though this year’s letter does not, as I noted at the outset, directly address succession planning, Buffett does provide a little reassurance in that area to Berkshire shareholders. He notes in the letter’s introductory section that Todd Combs and Ted Wechsler, the two investment managers he recently hired, not only outperformed the S&P 500 in 2012 by “double-digit margins,” but he also notes (in tiny type-face) that their returns “left me in the dust as well.” He also notes that the value of Berkshire’s investments in one of the companies in which both Coombs and Wechsler have invested – Direct TV – now exceeds $1 billion and therefore qualifies as one of Berkshire’s 15 top common stock investments. Buffett also notes that as a result of these two manager’s investment returns “we have increased the funds managed by each to almost $5 billion” including amounts coming from the pension funds of some of the subsidiaries.

 

In case anyone misses the significance of these portions of the Berkshire letter, Buffett adds that “Todd and Ted are young and will be around to manage Berkshire’s massive portfolio long after Charlie and I have left the scene. You can rest easy when they take over. “ Lest anyone have any doubts about these two investment managers’ vigorous youth, Buffett notes (in talking about the 5K race to be run at the upcoming shareholders’ meeting) that Wechsler has run a marathon in 3:01 and Coombs has run a 5K in 22 minutes. (I find this emphasis on vigorous youth amusing in an annual report for a company whose annual meeting has for years has featured what amounts to a comedy routine by a couple of wise-cracking senior citizens)

 

And though Buffett says nothing about the current paralysis in Washington, he does have a message of hope for investors discouraged by the many problems besetting the world: “I made my first stock purchase in 1942 when the U.S. was suffering major losses throughout the Pacific war zone. Each day’s headlines told of more setbacks.” Throughout the period since, “every tomorrow has been uncertain. America’s destiny, however, has always been clear: ever-increasing abundance.” Berkshire is backing up these words with actions. In 2012, the company invested $9.8 billion in plant and equipment, with 88% of that investment in the United States – a figure that is 19% higher than in 2011, which was the previous high. “Opportunities,” Buffett writes, “continue to abound in America.”

 

Buffett focuses a portion of his letter talking about what he calls Berkshire’s “big four” investments – American Express, Coca-Cola, IBM and Wells Fargo. Buffett notes that Berkshire’s ownership interest in all four increased during 2012 and “is likely to increase in the future.” For long-time Buffett devotees such as myself, the inclusion of American Express, Coca-Cola and Wells Fargo on this this list is unremarkable, as all three are long-time Berkshire holdings. The show-stopper is IBM, the shares of which Buffett acquired for the first time in 2011. Not only is IBM now a “big four” investment, but the cost of Buffett’s IBM investments is larger than the cost of any other current common stock investment in Berkshire’s portfolio (the current value of the IBM investment is second only to Wells Fargo). After nearly a half a century of refusing to invest in technology companies because he said he didn’t understand them, Buffett’s most costly common stock investment is in a technology company. Clearly, Buffett’s little frolic into newspaper acquisitions is not the only instance where Buffett has strayed from his “oft stated” investment principles.

 

For readers of this blog, one area of particular interest will be Buffett’s analysis of Berkshire’s insurance businesses, which, according to Buffett, “shot the lights out last year.” The businesses have not only given Berkshire $73 million of “float” to invest, but also collectively produced a $1.6 billion pre-tax underwriting gain – the tenth consecutive year Berkshire’s insurance businesses collectively posted an underwriting profit. The underwriting profit, remarkable under any circumstances, is all them more noteworthy given the devastating impact of Hurricane Sandy. Among other things, for GEICO, Sandy represented the “largest single loss in history,” three times larger than the loss from Hurricane Katrina. From my reading of Berkshire’s financial statements, the insurance businesses produced a post-tax underwriting profit of $1.0 billion on earned premium of $34.5 billion, implying (on a rough calculation) a combined ratio of about 97.1.  

 

Buffett ruefully notes that the production of an underwriting profit is not uniform across the insurance industry; once again, as he has in several past shareholder letters, Buffett calls out State Farm, naming and shaming one of GEICO’s biggest competitors, because as of 2011, it had produced an underwriting loss in eight of the last eleven years. (The company’s 2012 results have not yet been released.) Buffett puts a concluding note on this condemnation with the observation that “There are a lot of ways to lose money in the insurance, and the industry never ceases searching for new ones.” (In fairness to State Farm and to readers of this blog, I should point out Buffett wrote almost the same identical things in his 2011 letter. Buffett does have a certain affinity for certain shop-worn themes.)

 

In his shareholder letter, Buffett emphasizes the sheer magnitude of the float that the insurance businesses have produced and how quickly it has grown. He doesn’t tease out how powerful the availability of this float is. It is only be reading through the footnotes of the accompanying financial statements that it can be learned that, in addition to the $1.6 billion in underwriting profit, the insurance businesses produced investment income of $3.4 billion.

 

Buffett concludes his analysis of the insurance business with a warning about the industry’s “dim prospects.” The industry has been benefitting from higher yields on its “legacy” bond portfolios. The yields on these older assets are much higher than are available today and that will be available “perhaps for many years.” As these legacy assets mature out of the portfolios, “earnings of insurers will be hurt in a significant way.”  

 

Much of the mainstream media coverage of Buffett’s letter has focused on the fact that by Buffett’s own reckoning, 2012 was a subpar year for Berkshire. Buffett himself notes the irony of using the term “subpar” to describe a year that produce a gain of $24.1 billion. But using the fact is that for only the ninth time in 48 years, the percentage gain in Berkshire’s book value was less than S&P’s percentage gain with dividends included. Because Buffett himself adopted this measure as Berkshire’s standard of comparison, it is fair to judge the company on that basis. But let’s be clear – Berkshire’s shareholders are not complaining.

 

In the twelve months, Berkshire’s share price has climbed a rather remarkable 27.28% (to an all-time high) compared to 11.16% for the S&P 500 The company had 2012 revenues $162 billion, which represents an increase of $13.2 billion over 2011’s $143 billion in revenue. As noted above, the company had 2012 year- end assets of $427.4 billion, compared to $392.6 billion at the end of 2011.

 

Berkshire’s shareholders may or may not be persuaded that they can “rest easy” when Buffett and Charlie Munger have left the scene. But for now, it seems likely that the company’s shareholders will be very happy once again to enjoy the octogenarians’ comedy routine at this year’s annual meeting. As for what may lie ahead, only time will tell.  All I know is that I happen to live with somebody who is exactly Buffett’s age, an experience that fills me with a great deal of trepidation about how long the current comedy routine will be amusing.

 

My review of the latest Buffett biography — "Tap Dancing to Work" — can be found here.

 

Plaintiff law firms continued to file lawsuits in connection with virtually every mergers and acquisitions transaction in 2012, according to an updated report from Cornerstone Research. The February 2013 report, which is entitled “Shareholder Litigation Involving Mergers and Acquistions” and which was authored by Robert M. Daines of Stanford Law School and Olga Koumrian of Cornerstone Research, shows that plaintiff law firms filed lawsuits on behalf of shareholders in 96 percent of M&A deals valued over $500 million and 93 percent of transactions valued over $100 million. Cornerstone Research’s February 28, 2013 press release regarding the report can be found here. The report itself can be found here.

 

According to the report, the litigation rate involving M&A deals in 2012 was essentially unchanged from 2011. In both 2011 and 2012, about 93% of all deals valued over $100 million attracted litigation, and 96% of all deals valued over $500 million attracted litigation. Deals valued over $100 million attracted an average of 4.8 lawsuits per deal in 2012 (down slightly from 5.3 per deal in 2011) and deals valued over $500 million attracted an average of 5.4 lawsuits in 2012 (down from 6.1 in 2011).

 

The report notes that after a contrary trend in recent years, in 2012 a larger percentage of cases were filed in Delaware. In 2012 39% of all M&A lawsuits were filed in Delaware compared to only 25% as recently as 2012. For Delaware Corporations, 16% of deals were challenged only in Delaware, compared with 9% in 2011 and only 2% in 2009.

 

Of the 58% of cases filed in 2012 that had been resolved, the majority (64%) settled. 33% of the resolved cases were dismissed and 3% were voluntarily withdrawn. (These case outcomes are roughly equal to prior years, although with a certain number of the 2012 cases yet unresolved the settlement rate is slightly higher than prior years.)

 

Of the 2012 cases that were settled, 81% of the settlements involved only additional disclosures (compared to 88% in 2011 and 76% in 2010). According to the report, “the parties in only one settlement acknowledged that litigation contributed to an increase in the merger price.” The deal termination fee was reduced in four cases and the parties reached agreement about appraisal rights in six cases. There were two large settlements in 2012, both relating to transactions announced in 2011: the $110 million settlement in the El Paso/Kinder Morgan case and the $49 million settlement in the Delphi Financial/Tokio Marine case.

 

The report includes a detailed table of the ten largest M&A lawsuit settlements during the period 2003-2012. As the report notes, most of the larger settlements in the table “included allegations of significant conflicts of interest.”

 

The average agreed-upon attorneys’ fee for the 2012 settlements was $725,000, The average fee in a disclosure only settlement was $540,000, down from $570,000 in 2011 and $710,000 in 2010. The report includes an analysis of the factors that influence the size of the fee request. The report notes that “plaintiff attorney fees appear to be influenced by the following factors: size of the settlement fund; other monetary benefit to shareholders; number of suits filed; time to settlement; and overall deal value.”

 

The report concludes with a review of the emerging litigation involving shareholder challenges relating to annual proxy votes and disclosures about executive compensation, which mounted quickly as 2012 progressed. The report notes that “as the 2013 proxy season approaches, this litigation may expand.”

 

Among the more controversial questions about the U.S.’s Foreign Corrupt Practices Act has been the extent of its reach in enforcement actions against foreign-domiciled individuals. Two recent decisions from the Southern District of New York reached differing conclusions about the statute’s reach. One case rejected the individual’s motion to dismiss the FCPA enforcement action, while the second granted the individual defendant’s motion to dismiss. Both decisions were based on the court’s personal jurisdiction over the individuals. The difference between the two decisions sheds some light on the question of extent of the FCPA’s reach over foreign individuals.

 

The first of these two rulings involved three executives of Magyar Telecom. The company was accused of involvement in schemes to bribe government officials in Macedonia and Montenegro. The company and its corporate parent, which were subject to U.S. jurisdiction because their securities (in the form of ADRs) traded on U.S. exchanges, entered into a non-prosecution agreement and also agreed to pay over $95 million in criminal fines and civil penalties.

 

The SEC also filed an enforcement proceeding against three Magyar executives. The SEC alleged that the three authorized payments to an intermediary, knowing the payments would be forwarded to government officials. The SEC also alleged that the individuals made false statements to the company’s auditors by signing representations that the company’s books and records were accurate. All three executives are Hungarian citizens and residents. The three moved to dismiss the SEC’s complaint, arguing that the U.S lacked personal jurisdiction over them.

 

In a February 8, 2013 order (here), Southern District of New York Judge Richard J. Sullivan denied the defendants’ motion to dismiss. Judge Sullivan held that the SEC had met its burden of showing that the exercise of personal jurisdiction over the three was consistent with constitutional due process. Judge Sullivan based his ruling not on the individuals’ physical location but their actions on Magyar’s behalf. The complaint, Sullivan observed, alleges that the defendants “engaged in a cover up through their statements to Magyar’s auditors knowing that [the company’s securities} traded on an American exchange and that prospective purchasers” would “likely be influences by any false financial filings.”

 

With respect to the question of whether or not the defendants had sufficient “minimum contacts” to support the constitutional exercise of jurisdiction, Judge Sullivan noted that “the Defendants here allegedly engaged in conduct that was designed to violate United States securities regulations and was thus necessarily directed toward the United States, even if not principally directed there.” He added that “because these companies made regular quarterly and annual consolidated filings during that time, Defendants knew or had reason to know that any false or misleading financial reports would be given to prospective American purchasers of those securities.”

 

Judge Sullivan specifically noted that his ruling did not envision any sort of rule that would subject any overseas employee of a company alleged to have violated the FCPA to personal jurisdiction in the U.S. He noted that “although Defendants’ alleged bribes may have taken place outside the Unites States…their concealment of those bribes, in conjunction with Magyar’s SEC filings, was allegedly directed toward the United States.”

 

The FCPA Blog’s post about the ruling can be found here. The FCPA Professor’s blog post about the Judge Sullivan’s ruling can be found here.

 

In the second of the two decisions, on February 19, 2013, Southern District of New York Judge Shira Scheindlin granted the motion to dismiss of one of the seven individual Siemens executives named in a FCPA enforcement action. Judge Scheindlin’s opinion can be found here. Siemens of course has been embroiled in one of the largest bribery investigations of all time. The SEC filed a separate enforcement action against several Siemens executives in connection with alleged bribery activities in Argentina. One of the defendants, Herbert Steffen, moved to dismiss contending that the court lacked personal jurisdiction over him. Steffen, a German citizen, had been CEO of Siemens Argentina twice before his retirement in 2003. He never worked in the U.S. The SEC alleged that Steffen helped facilitate a bribe to the Argentinian president to help secure a large government contract by allegedly encouraging another Siemens official to authorize bribes of Argentinian officials

 

In granting Steffen’s motion, Judge Scheindlin found that Steffen lacked sufficient contacts with the U.S. and dismissed the case against him. Judge Scheindlin found that “Steffen’s actions are far too attenuated from the resulting harm to establish minimum contacts.” She noted that “the SEC does not allege that he directed, ordered or even had awareness of the cover ups … much less that he had any involvement in the falsification of SEC filings in furtherance of the cover ups.”

 

Judge Scheindlin went on to observe that the exercise of jurisdiction over foreign defendants based on their effects upon SEC filings is “in need of a limiting principle,” adding that “if this Court were to hold that Steffen’s support for the bribery contact satisfied the minimum contacts analysis, even though he neither authorized the bribe, nor directed the cover up, much less played any role in the falsified filings, minimum contacts would be boundless.”

 

In further considering whether it would be reasonable for the Court to exercise jurisdiction over Steffen, Judge Scheindlin noted that “Steffen’s lack of geographic ties to the United States, his age, his poor proficiency in English and the forum’s diminished interest in adjudicating the matter all weigh against personal jurisdiction.” She added that the SEC and the Department of Justice “have already received comprehensive remedies against Siemens” and “Germany has resolved an action against Steffen individually.”

 

The FCPA Blog’s discussion of Judge Scheindlin’s ruling (as well as a detailed discussion of the larger background regarding the anti-bribery enforcement proceedings involving Siemens) can be found here. Victor Li’s February 20, 2013 Am Law Litigation Daily article about the ruling can be found here.

 

These two cases reached differing results, although the differing outcomes obviously depended on some very case-specific factual differences. Outcomes of personal jurisdiction motions often are very fact specific. For that reason it could be argued that there is little significance to the fact that in one case the Court found that it had personal jurisdiction over the individual defendants and in another it did not.

 

Though personal jurisdiction rulings are notoriously fact-specific, there nevertheless are certain conclusions that can be drawn from these two decisions, particularly in consideration of the question when a foreign domiciled individual charged with an FCPA violation can be subject to personal jurisdiction in the U.S. As James Dowden and Nick Berg of the Ropes & Gray law firm noted in their February 27, 2013 Law 360 article entitled “Rare Guidance On FCPA’s Reach Over Foreign Nationals” (here, registration required), the two cases “reaffirm U.S. regulators’ long-standing position that the FCPA has broad applicability to foreign nationals, while also setting the outer limits of the civil scope of the FCPA.”

 

In that regard, Judge Scheindlin herself not only referred to Judge Sullivan’s ruling in the Magyar executives’ case, but she identified the critical distinctions between the two cases. She noted first that “there is ample (and growing support in the case law for the exercise of jurisdiction over individuals who played a role in falsifying or manipulating financial statements relied upon by U.S. investors in order to cover up illegal actions directed entirely at a foreign jurisdiction.” She cited Judge Sullivan’s ruling the Magyar executives’ case as an example where the court “exercised jurisdiction over individuals who orchestrated a bribery scheme … and as part of the bribery scheme signed off on misleading management representations to the company’s auditors and signed false SEC statements.”  However, as noted above, Scheindlin found that the Siemens executive in the case before her was not alleged to have been involved in the cover ups or the falsification of the SEC filings.

 

At a minimum, the two rulings signify that though U.S. courts may properly exercise personal jurisdiction over foreign individuals in FCPA enforcement action when the facts support jurisdiction, there is a also a point when a foreign-domiciled individual’s involvement in the alleged corrupt activity is too attenuated to support personal jurisdiction. The specific considerations that matter include the extent of the individual’s connection to the actual bribery, the extent of the individual’s role in any cover-up of the bribery, and the extent of the individual’s involvement in or contribution to the falsification of the company’s financial statements.

 

A February 2013 memorandum from the Arnold & Porter law firm discussing the two cases and entitled “Two Recent Decisions Address Jurisdiction Over Foreign Defendants in FCPA Cases” can be found here.